# Discounted Cash Flow by hqh17862

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```									Discounted Cash Flow (DCF)
Tutorial
Wednesday, January 31st, 2007
Tutorial Objectives
• Basic Underlying Principles
– Time Value of Money
– Present/Future Value
– Opportunity Cost
• What is a business worth?
• What is Free Cash Flow?
• Basics of DCF Analysis
– Compostion
– Computation
– Forecasting
Present Value
• Time Value of Money: A dollar today is worth more
than a dollar tomorrow.
– A dollar today can be invested to earn a rate of return or
interest.
• What is today’s dollar worth tomorrow (future value)?
 ( )
FVPV i N
1
• What is tomorrow’s dollar worth today (present value)?

FV
PV /( i
1 )              N
Time Value: Example
• You are given \$5,000 and decide to invest it in
the stock market for 10 years and expect an
average annual rate of return of 10%. What is
that \$5,000 worth 10 years from now?
000
,
5 ( %)
\$
FV * 10 1                 10
years

 12
FV \$ ,969
• Likewise…         12 
, 1
\$969
PV /( %)  10                yea
10

5
PV \$ ,000
• A business is worth the present value of the
expected future cash flows of the business.
• A company's stock price is a reflection of the
market's concensus expectation regarding the
value of the equity in the business.
Ex. Target Corp (TGT):
\$60 Share Price
x 858.89 Shares Outstanding (mm)
= \$51,533 Market Capitalization or Market Value of Equity
• Is the market always right?
Capital Budgeting
• The process of determining how a firm should allocate scarce
resources to available long term investment opportunities
• Decisions whether a company should undertake a given project
• Goal: Increase (Maximize) shareholder wealth
• One capital Budgeting tool is NPV

er
Ya 0           er
Ya 1         er
Ya 2      er
Ya 3
\$ 00 0
( 3, 0)         30 0
\$, 0        1, 0
\$ 00 0    2, 0
\$ 50 0

is o n ae
D c u t Rt :             0
1%
e r s n au
Nt Pe e t V l e      \$2. 9
( 2 53 )
Discount Rate
• The interest rate at which you discount
expected future cash flows to the present
• Efficient Markets Hypothesis (EMH)
– Finance theory which states that all stock market
prices at any given time reflect the accurate present
value of the future cash flows of a business
– Assumes market as a whole has rational
expectations and is always right
– Uses Capital Assets Pricing Model (CAPM) to
establish the theoretical 'cost' of equity
Discount Rate
• EMH uses Beta as a measure of risk by
quantifying the stock's volatility (up and down
movements) relative to the market.
– Since the stock price reflects the PV of future cash
flows, the more volatile the stock price, the more
uncertain the future performance of the business.
– This 'extra risk' is reflected in a higher Cost of
Equity. (Risk/Return)

Cost of Equity = Rf + B * (Mkt – Rf)
Discount Rate
"I'd be a bum on the street with a tin cup if the
markets were always efficient" – Warren Buffett

• The Opportunity Cost of Money –
– Also known as the Hurdle Rate
• The expected rate of return available on
alternative investment opportunities
– Historically, the stock market has generated an
average annual return of about 10%.
Discounted Cash Flow Analysis
• Same Concept as capital budgeting: Is a \$60 per
share ‘initial investment’ in Target Corp. worth the
projected future cash flows of this business given a
discount rate of 10%?
• Instead of a CFO conducting Capital Budgeting
analyses to evaluate the projected cash flows of
projects for his/her company to invest in, we are a
fund conducting DCF analyses to evaluate the
projected cash flows of whole companies.
Free Cash Flow – Equity (FCFE)
• Net Income adjusted for all non-cash sources
of revenue and expense, less capital
expenditures
– Ex. Subtract all revenue paid for on credit, and add
all expenses paid for on credit
– Add back depreciation – largest non-cash expense
• The cash that is left for shareholders after debt-
holders have been paid and necessary
• FCFE is what we care about!
Free Cash Flow – Equity (FCFE)
Net Income

Less: Capital Expenditures (CAPEX)

= Free Cash Flow to Equity
DCF Example

Year 0      Year 1     Year 2     Year 3
Initial Cost     (50,000)
Operating Income                  75,000     84,000    100,000
Taxes (34%)                      (25,500)   (28,560)   (34,000)
Income                           \$49,500    \$55,440    \$66,000
Plus: Depreciation                 3,750      4,200      5,000
Minus: CapEx                       4,500      5,040      6,000
Free Cash Flow       (\$50,000)    \$48,750    \$54,600    \$65,000
Discount Rate            10%
Discounted Values (\$50,000)       \$44,318    \$45,123    \$48,835
Present Value         \$88,277
Terminal Cash Flow
• Going Concern Assumption: The business will
operate and generate cash flows indefinatley.
– Zero Growth: CF / i
• \$48,835/0.10 = \$488,350
– 5% Growth: CF*(1+g) / (i-g)
• \$48,835*(1.05)/(.05) = \$1,025,535
• Liquidation: Sell off remaining assets in
liquidation.
– PV of Fixed Assets: \$52,590/(1+10%)^3
=\$39,511
Forecasting Cash Flows
• Historical performance is not important in terms
of business value, but is important in terms of
predicting future performance.
• The trickiest part of business valuation
– Future performance is unknowable
• Things to consider when predicting the future:
– Every projection should be backed by a rational
argument
– The strongest arguments will include both
quantitative and qualitative support
– Mean Reversion
Forecasting Cash Flows
• Historical Simple/Weighted Averages
– Primarily used when there is no discernable trend,
or current trend is not expected to continue
Year 1   Year 2   Year 3   Year 4   Year 5
Net Income Growth    7%       12%      8%       1%       5%

Simple Average                        6.60%

Weighted Average    Weight  Growth
33.3%     5%      1.7%
26.7%     1%      0.3%
20.0%     8%      1.6%
13.3%    12%      1.6%
6.7%     7%      0.5%
100.0%             5.6%
Forecasting Cash Flows
• Historical Trend Exrapolation

Year 1   Year 2   Year 3   Year 4   Year 5
Net Income Margin      4%       4%       4%       5%       6%

Year 6   Year 7   Year 8   Year 9   Year 10
Estimated NI Margin    6%       7%       8%       8%        8%
What We've Covered
• Basic Underlying Priciples
– Time Value of Money
– Present/Future Value
– Opportunity Cost
• What is a business worth?
• What is Free Cash Flow?
• Basics of DCF Analysis
– Compostion
– Computation
– Forecasting

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